The Cheaper, Safer Investment Option Right Now

Investors face a huge amount of uncertainty right now. Stocks are up modestly for the year, but they're well off their highs. Bonds have posted some significant gains, but their yields are at rock-bottom levels, and you have to take on some credit risk to get decent yields on most bonds. Even dividend stocks, which many used to consider boring and unremarkable, have seen their prices rise so far that some worry they're looking bubbly. Yet on the whole, investors don't seem particularly fearful about the prospects for an imminent decline.

When you add all those factors up, it's time to take a closer look at a strategy most people never think of: Buying options.

Buy low, sell highMany investors dismiss options because of their reputation as being purely speculative. Sure enough, you'll find no shortage of get-rich-quick schemes involving options, trying to lure you in with the prospect of quick 1,000% returns.

But smart investors understand that options are only as risky as the particular strategies you use with them. Just as some stocks will take you for the ride of your life while others are relatively stable, so too can you choose a variety of different risk levels depending on how you use options.

In particular, now's a good time to consider buying options. Conservative investors tend to sell options, reaping small premiums rather than paying them. But options are relatively cheap right now, and so it makes more sense to be a buyer of options than a seller. Moreover, options can give you more favorable risk-reward prospects than buying shares outright.

What's in an option?To understand why options prices are attractive right now, you need to understand how option prices work. An option's price depends on several things: the price of the underlying stock, the strike price at which the option calls for you to buy or sell shares, the amount of time left until the option expires, and the volatility of the underlying stock. With current volatility levels low, options prices are lower than they would be under more normal circumstances.

Those cheap prices make it possible for you to capture most of the same upside potential of owning shares while limiting your downside. For instance, Baidu (Nasdaq: BIDU) has lost a third of its value in less than a year as China's economy has slowed down. If you think it will bounce back, you could buy shares at around $109. But you could also pay about $18 per share for options to buy Baidu stock for $100 any time between now and January. Similarly, PotashCorp (NYSE: POT) has had a wild ride as strong farm demand battles with high potash mining costs. You can buy shares for around $44.50, or a call option for $6.75 per share to pick up the stock any time before mid-January for $40.

In both cases, the tradeoffs are clear. If you end up exercising the option, you'll pay more in total for your shares -- $9 more in Baidu's case, and $2.25 for PotashCorp. But you'll have two advantages to counterbalance that extra cost. You won't put as much money at risk, as the most you stand to lose is whatever you pay for the call option. And if the stock price drops sharply, you don't have to buy the shares. Rather, you can just let them expire unexercised, saving you from an even bigger loss.

Playing volatilityOddly enough, in some situations, you can profit from options even if the price action moves against you. Rising fear about the stock market can push implied volatility up, bringing options prices up with it even if the shares don't budge. Compared to exchange-traded volatility playsiPath S&P 500 VIX Short-Term (NYSE: VXX) or VelocityShares Daily 2x VIX Short-Term (NYSE: TVIX) , using options directly to bet on volatility is less prone to tracking error or other potential mishaps.

Options aren't for everyone. But if you're looking to reduce your overall risk level while still retaining some upside, today's relatively cheap option price environment is tailor-made for strategies using options.

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If you want to "reduce your overall risk level while still retaining some upside", simply transfer 30% of your portfolio to cash and keep the rest fully invested (adjust % in cash to your risk tolerance level).

With respect, it's not misleading at all. Options let you invest less money than you would buying stock, and they can protect you from big drops. Ask shareholders in any of the stocks that have recently dropped 50% or more whether they wish they had bought call options rather than outright shares.

Mr. Market sometimes speaks in mysterious tongues, and you really have to wonder what he is struggling to tell us by taking the Volatility Index (VIX) down to a subterranean $13 handle on Friday, a new five year low.

A number of advisors have been recommending that investors load up on the (VIX) in recent months to give them downside protection from an imminent market crash. Those who followed such advice were hammered, their clients no doubt striking them off invitation lists for summer barbeques.

In the past month, the (VIX) has cratered from $20 to $13. Just last October, it touched $49, when I urged readers to pile in on the short side. I came out in the mid-$30’s weeks later.

Those who traded the triple leveraged (TVIX) fared even worse, this blighted ETF plunging from $5 to $2.50 during the same period. The (TVIX) is doing the best impression of an ETF going to zero that I know of. A year ago it was trading at $110. This is why I plead with traders to avoid triple leveraged ETF’s like the plague. These things are designed for day trading by hedge funds only. Eventually, they all go to zero.

I am even seeing this in my own portfolio. A week ago, I sold short the September, 2012 (SPY) $147 calls at $0.38. A week later, the (SPY) has risen by 1.2% but the call options have done a swan dive to $0.34. This can only happen when they are crushing volatility.

I quit recommending (VIX) plays in March when I realized that there is some sort of arbitrage going on in the hedge fund community that is punishing (VIX) owners. I haven’t figured out the exact mathematical dynamics yet, but it has to involve selling short the cash stocks and shorting (VIX) contracts against them. Whatever they lose on the cash short is more than made up by the profits on their (VIX) short.

It’s easy to see how successful this would be. While August (VIX) traded at a lowly 13.40%, September volatility is still up at 18%, and January, 2013 is trading at a positively nosebleed 25%. That spread provides a lot of room to take in some serious money.

So what is the 13% really trying to tell us? Here are some thoughts:

*It is discounting multiple tranches of quantitative easing by central banks around the world that take all asset prices up for the rest of the year.

*It reflects the complete abandonment of the stock market by the individual investor, which is why trading volume has collapsed.

*It also indicates how exchange traded funds are taking over, sucking volume out of the stock market. The (VIX) doesn’t reflect activity in ETF’s.

*It could be discounting an Obama win in the presidential election. Stocks have delivered a 72% return since the Obama inauguration, the third best in history after Franklin Roosevelt and Bill Clinton. Mixed stock and bond portfolios have delivered the best returns on record, with both asset classes appreciating dramatically for 3 ½ years, something that never happens.

It could be that the (VIX) at this level has it all wrong, and that a stock market selloff is about to send it soaring. Those who have rigidly held on to that belief until now have been severely tested.

For those who have fortunately avoided the (VIX) trade so far, let me give you a quick primer. The CBOE Volatility Index (VIX) is a measure of the implied volatility of the S&P 500 stock index. You may know of this from the talking heads on TV, beginners, and newbies who call this the “Fear Index”.

For those of you who have a PhD in higher mathematics from MIT, the (VIX) is simply a weighted blend of prices for a range of options on the S&P 500 index. The formula uses a kernel-smoothed estimator that takes as inputs the current market prices for all out-of-the-money calls and puts for the front month and second month expirations.

The (VIX) is the square root of the par variance swap rate for a 30 day term initiated today. To get into the pricing of the individual options, please go look up your handy dandy and ever useful Black-Scholes equation. You will recall that this is the equation that derives from the Brownian motion of heat transference in metals. Got all that?

For the rest of you who do not possess a PhD in higher mathematics from MIT, and maybe scored a 450 on your math SAT test, or who don’t know what an SAT test is, this is what you need to know. When the market goes up, the (VIX) goes down. When the market goes down, the (VIX) goes up. End of story. Class dismissed.

The (VIX) is expressed in terms of the annualized movement in the S&P 500. So a (VIX) of $13 means that the market expects the index to move 3.8%, or 53 S&P 500 points up or down, over the next 30 days. You get this by calculating 13%/3.46 = 3.8%, where the square root of 12 months is 3.46. The volatility index doesn’t really care which way the stock index moves. If the S&P 500 moves more than the projected 3.8%, you make a profit on your long (VIX) positions.

Probability statistics suggest that there is a 68% chance (one standard deviation) that the next monthly market move will stay within the 3.8% range. I am going into this detail because I always get a million questions whenever I raise this subject with volatility deprived investors.

It gets better. Futures contracts began trading on the (VIX) in 2004, and options on the futures since 2006. Since then, these instruments have provided a vital means through which hedge funds control risk in their portfolios, thus providing the “hedge” in hedge fund.

But wait, there’s more. Now, erase the blackboard and start all over. Why should you care? If you buy the (VIX) here at $13, you are picking up a derivative at a nice oversold level. Only prolonged, “buy and hold” bull markets see volatility stay under $20 for any appreciable amount of time. If you don’t believe that we are in such a bull market now, you should be buying (VIX) on every dip.

A bet that euphoria doesn’t go on forever and that someday something bad will happen somewhere in the world seems like a good idea here. You would think that is a no brainer with a Fed disappointment on QE3, a fiscal cliff, and a 2013 recession on the horizon. But right now, the burden of proof is on the market as to exactly when is the right time to do that. And for the (VIX) to work well, bad things have to happen quickly, preferably by tomorrow.